Chaptger 9: Inventories

Learning objectives

1. The relationship between inventory valuation and cost of goods sold. 2. The two methods used to allocate the total inventory cost between the COGS and the ending inventories—perpetual and periodic. 3. What kinds of costs are included in inventory. 4. What absorption costing is and how it complicates financial analysis. 5. The difference between inventory cost flow assumptions—weighted average, FIFO and LIFO.
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6. How LIFO reserve disclosures can be used to estimate inventory holding gains and to transform LIFO firms to a FIFO basis. 7. How LIFO affects firms’ income taxes. 8. How to eliminate realized holding gains from FIFO income.

Learning objectives concluded

9. Economic incentives guiding the choice of inventory methods.
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10.How to apply the lower of cost or market method. 11.The key differences between GAAP and IFRS requirements for inventory accounting.

Learning objectives concluded

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Acquire and process raw materials into finished goods. 4  Merchandising Companies:   Manufacturing Companies  . Entertainment. Wholesalers and retailer: to buy and sell ready-to-sell merchandise. etc.Main Types of Businesses  Service Companies:  Travel agency. Internet.

inventory accounting is crucial to financial reporting.Main Types of Businesses For both merchandising and manufacturing companies. inventories are important assets.  5 .  Therefore.

Inventory types Wholesaler or retailer: Manufacturer Firm Manufacturer: Supplier Firm Raw materials Work-in-process Finished goods Merchandise inventory Customer Gross Profit: Sales – Cost of Goods Sold Includes other manufacturing costs ( Direct labor costs. direct materials.) Customer 6 . manufacturing overhead. etc.

Overview of accounting issues Old unit New unit Issue: What kind of costs are included in inventory? Issue: How is the cost of goods available for sale split between the balance sheet and the income statement? 9-7 .

 If the cost of inventory never changes. all three cost flow assumptions would yield the same financial statement result. the total dollar amount assigned to the balance sheet and the income statement is the same ($640 in this example).  No matter what assumption is used.Overview of accounting issues: Summary  Three methods for allocating the cost of goods available for sale: Weighted average  GAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory. FIFO LIFO 9-8 .

LIFO produces a larger expense 9-9 . First-in. first-out (FIFO) approach: Oldest unit cost flows to income. last-out (LIFO) approach: Newest unit cost flows to income.Overview of accounting issues: Allocating the cost of goods available for sale Weighted average approach: Uses the the average average cost cost of of the the two two Uses units. FIFO produces a smaller expense Last-in. units.

periodic)? 9-10 .e.Overview of accounting issues:     How to allocate total inventory between the COGS and the ending inventory? What items should be included in ending inventory? What costs should be included in inventory purchases (and eventually in ending inventory)? What different cost flow assumptions can be used in determine the COGS under each inventory method (i. perpetual vs..

Learning Objective: How to allocate total inventory between the COGS and the ending inventory? 11 .

The inventory T-account under a perpetual inventory system looks like this:  Entries are made as units are purchased Entries are made as units are sold 12 .Perpetual inventory system  This approach keeps a running (or ―perpetual‖) record of the amount of inventory on hand.

Determining inventory quantities: Periodic inventory system  This approach does NOT keep a running (or ―perpetual‖) record of the amount of inventory on hand. 13 . Entries are made as units are purchased  Ending inventory and cost of goods sold must be determined by physically counting the goods on hand at the end of the period.

(1.500)=COGS (7. (3.000) 14 .Determining inventory quantities: Journal entries illustrated Beginning Inv.400) + Purchases (9.100) – Ending Inv.

Typically used for low volume. Less management control over inventory.    15 . Typically used when inventory volumes are high and per-unit costs are low. Better management control over inventories including ―stock outs‖. Does NOT eliminate the need to take a physical inventory. More complicated and usually more expensive.    COGS is a ―plug‖ figure and there is no way to determine the extent of inventory losses (―shrinkage‖). high unit cost items or when continuous monitoring of inventory levels is essential.Periodic and perpetual compared Periodic inventory  Perpetual inventory  Less recordkeeping means lower cost to maintain.

16 .Learning Objective: What items should be included in ending inventory? .

  Goods in transit may be ―owned‖ by the buyer or the seller. When it comes to preparing financial statements. most firms record inventory when they physically receive it. 9-17 . The party that has legal title during transit will record the items as inventory. the firm must determine whether all inventory items are legally owned.Items included in inventory   In day-to-day operations.  Consignment goods should not be counted as inventory for the consignee.

regardless of their location.What is Included in Ending Inventory? General Rule All goods legally owned by the company on the inventory date. Goods in Transit Goods on Consignment Depends on FOB shipping terms. 18 .

. 19 . buyer’s facility.Goods in transit  The party with the legal title during transit will record the items as inventory. Thus. FOB Destination: the title transfers to the buyer at the destination (i.e. the seller’s facility).. the buyer has the title during the transit.e. the seller has the title during the transit.   FOB Shipping Point: the title transfers to the buyer at the shipping point (i. Thus.

20 . Sold inventory ―FOB Shipping Point‖. 2. shipped on 12/31/10. 4. 1. Sold inventory ―FOB Destination‖. shipped on 12/31/10. shipped on 12/31/10. Indicate whether the inventory would be included in Houston’s ending inventory on 12/31/2010. 3. Purchased inventory ―FOB Destination‖. shipped on 12/31/10. Purchased inventory ―FOB Shipping Point‖.In Class Exercise : Houston Corporation had the following inventory transactions in transit on 12/31/08.

Learning Objective: What costs should be included in inventory purchases? 21 .

Costs included in inventory

All costs necessary to obtain the inventory and to make it saleable should be accounted for. These costs include:  Purchase cost or production costs  Sales taxes and transportation costs (if paid by the buyer).  In-transit insurance costs (if paid by the buyer).  Storage costs.
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Costs included in inventory

In theory, costs such as the costs of the purchasing department and other general and administrative costs associated with the acquisition and distribution of inventory should also be included in the inventory costs(referred to as the ―indirect‖ costs‖).

However, most firms exclude these items.

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Costs included in inventory :

Non-manufacturing firms consider the following items in the cost of inventories:  Purchase costs ( invoice price)  + Freight-in (transportation-in)  - Purchase returns  - Purchase allowances (reduce the purchase price due to damages on goods).  - Purchase discounts (from early cash payments for the purchase) .
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product costs)of a manufacturer include:  Raw Material (variable)  Direct Labor (variable)  Overhead items:  Variable overhead: indirect labor. property taxes of factories. 25 . electricity used for production. etc.. rent expense for the factories. indirect material.  Fixed overhead: depreciation expense of machine.Costs included in inventory: Manufacturing firms The inventory costs (i.e. etc.

labor and overhead in production process and in finished goods account when the production process is complete) until finished goods are sold.Costs included in inventory: Manufacturing firms (contd. 26 When . finished goods are sold.) The inventory costs are treated as assets (in work-in-process account for any raw material. the carrying value of these finished goods is charged to cost of goods sold.

Costs included in inventory: Manufacturing industry ( FYI ) Two views on treatment of manufacturing overhead costs: Absorption and variable costing 27 .

Manufacturing Overhead: Variable costing versus Absorption costing Fixed production costs Variable costs will change in proportion to the level of production. Fixed overhead:  Manufacturing rentals and depreciation  Property taxes Variable production costs Variable costing of inventory (not allowed by GAAP) Variable production costs  Raw materials  Direct labor  Variable overhead. The rationale for absorption costing is that both variable and fixed production costs are assets since both are needed to produce a saleable product. 28 . like electricity Absorption costing of inventory (required by GAAP) Costs are considered to be Includable in inventory if they provide future benefits to the firm.

29 . These are never included in inventory.Manufacturing Overhead: Summary This approach is not allowed by GAAP.

the GAAP gross margin increases from $110.000 in 2012 even though variable production costs and selling price are constant. 9-30 .Costs included in inventory: How absorption costing can distort profitability  As we shall see. and sales revenue has fallen.000 in 2011 to $130.

Costs included in inventory: Absorption costing distortion 9-31 .

Costs included in inventory: Variable costing illustration Under variable costing the gross margin falls 9-32 .

33 .Absorption Costing and Earnings Management (source: RCJM Textbook) A research study found that firms in danger of producing zero earnings resort to overproducing inventory to reduce sort of goods sold and thereby boost profits. The evidence suggests that absorption costing provides opportunities for firms to manipulate earnings.

FIFO.Cost Flow Assumptions: Differentiate between the specific identification. LIFO. and average cost methods used to determine the cost of ending inventory and cost of goods sold. 34 .

a cost flow assumption is required.  For most firms. however.  9-35 . it is possible to identify which particular units have been sold. Examples include jewelry stores and automobile dealerships.Cost flow assumptions: The concepts In a few industries. These firms use specific identification inventory costing.

Cost Flow Assumptions: Allocating the cost of goods available for sale
Assumption: the cost of inventory is rising Older inventory purchase: Unit price:$300 Most recent inventory purchase: Unit price ;$340

Weighted average
Uses the average cost of the two units.
FIFO produces a smaller expense

First-in, first-out (FIFO)
Oldest unit cost cost flows to income. Oldest unit flows to

income.

Last-in, first-out (LIFO)
Newest unit cost flows to income.

LIFO produces a larger expense

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Cost Flow Assumptions: Summary

GAAP does not require the cost flow assumption to correspond to the actual physical flow of inventory. If the cost of inventory never changes, all three cost flow assumptions would yield the same financial statement result. No matter what assumption is used, the total amount assigned to the balance sheet and the income statement is the same (i.e., the amount of goods available for sale).
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Cost flow assumptions: What assumptions do firms use?(Accounting Trends and Techniques)

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first-out (LIFO) 39 .Inventory Cost Flow Methods     Specific cost identification Average cost First-in. first-out (FIFO) Last-in.

Examples include jewelry stores and automobile dealerships. 40   COGS for each sale is based on the specific cost of the item sold.Specific Cost Identification Companies which can identify specific units sold can adopt the specific identification method to allocate costs of goods sold and cost of ending Inventory. income may be manipulated.  The specific cost of each inventory item must be known. By selecting specific items from inventory at the time of sale. .  Items are added to inventory at cost when they are purchased.

Weighted Average Cost Method Periodic average cost uses a weighted-average unit cost: Weightedaverage unit cost Cost of goods = available for sale ÷ Quantity available for sale Perpetual average cost uses a moving average unit cost that is recomputed each time a new purchase is made. 41 .

00 $180 Purchase 1/10 40 @ 10.Begin Inventory 20 @ $ 9.55=35 units  Weighted Average Method – Periodic system Average unit cost: $ of Goods available cost( 180+400+330 ) = $10.11 = $354 Cost of Goods Sold: $180+ (400+330)– 354 = $556 42 .00 330 Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40 + 30 .11per unit Units of Goods available ( 20+40+30 )   Ending Inventories: 35 units x $10.00 400 Purchase 1/22 30 @ 11.

81 Goods available units ( 20+40-55+30 ) 35  Cost of ending inventory on 1/31: 35 units x $10.81 per unit = $378.85  Calculate weighted average unit cost on1/22: Goods available cost ( 5*9.67 per unit Goods available units ( 20+40 ) 60  Cost of Goods sold on 1/13: 55 units x $9.00 400 Purchase 1/22 30 @ 11.00 $180 Purchase 1/10 40 @ 10.00 330 Sales 1/13 : 55 Units Ending Inventory on 1/31:20 + 40+ 30 – 55 = 35 units  Calculate weighted average unit cost on 1/10: Goods available cost ( 180+400 ) = $580 = $9.35 43 .67 per unit = $ 531.67+30*11) = $378 = $10.Weighted Average Method – Perpetual system Begin Inventory 20 @ $ 9.

The cost of the newest inventory items remain in ending inventory. 44 . The cost of the oldest inventory items are charged to COGS when goods are sold. The COGS and ending inventory cost are the same under periodic and perpetual approaches regardless their differences in the timing of adjustments to inventory. First-Out     The FIFO method assumes that items are sold in the chronological order of their acquisition.First-In.

First-in. First-out (FIFO) Newest units assumed still on hand Oldest units assumed sold 45 .

First-out (FIFO) illustrated The computations are: 46 .First-in.

Inv. Inv. FIFO for COGS (top down) – end.Practice Problem: FIFO .00 Sales on 1/13: 55 Units Ending Inventory: 20+40+30-55 = 35 units  $180 $400 $330 FIFO of cost of ending units (bottom up) : 30 @ $11 = $330 Alternatively 5 @ $10 = $ 50 (recommended). + net pur.00 Purchase 1/10 40 @ 10.00 Purchase 1/22 30 @ 11.Periodic system Beginning Inventory 20 @ $ 9. Total = $380 COGS = beg. Total = $530 35 units 47  . 55 units 20 @ $ 9 = $180 = $180 + (400+330) 35 @ $10 = $350 – 380 = $530.

Practice Problem: FIFO -Perpetual system Beginning Inventory 20 @ $ 9.00 $330 Sales on 1/13: 55 Units Ending Inventory: 20 + 40+ 30 .00 $180 Purchase 1/10 40 @ 10.55 = 35 units  FIFO COGS for 1/13 Sale FIFO Inventory on 1/13 55 units 20 @ $ 9 = $180 5 @ $10 = $50 35 @ $10 = $350 Total = $530  Inventory on 1/22 (same as inventory on 1/31 due to no other transactions after 1/22 in January) 35 units 5 @ $10 = $ 50 30 @ $11 = $330 Total = $380 48 .00 $400 Purchase 1/22 30 @ 11.

First-Out     The LIFO method assumes that the newest items are sold first. leaving the older units in inventory. Unlike FIFO. using the LIFO method may result in COGS and ending inventory Cost that differ under the periodic and perpetual approaches. The cost of the oldest inventory items remain in inventory. The cost of the newest inventory items are charged to COGS when goods are sold.Last-In. 49 .

First-out (LIFO) Newest units assumed sold Oldest units assumed still on hand 50 .Last-in.

Last-in. First-out (LIFO) illustrated The computations are: 51 .

Practice Problem: LIFO . 55 units 30 @ $11 = $330 = $180 + (400+330) 25 @ $10 = $250 – 330 = $580. Total = $330 COGS = beg.00 Purchase 1/10 40 @ 10. Inv. Inv.00 Sales on 1/13: 55 Units Ending Inventory: 20+40+30-55 = 35 units  $180 $400 $330 LIFO of cost of ending inventory (top down) : 20 @ $9 = $180 Alternatively 15 @ $10 = $150 (recommended).Periodic system Beginning Inventory 20 @ $ 9. + net pur. Total = $580 35 units 52  .00 Purchase 1/22 30 @ 11. FIFO for COGS (bottom up) – end.

55 = 35 units  LIFO COGS for 1/13 Sale LIFO Inventory on 1/13 55 units 40 @ $10 = $400 5 @ $9 = $40 15 @ $9 = $135 Total = $535  Inventory on 1/22 (same as inventory on 1/31 due to no other transactions after 1/22 in January) 35 units 5 @ $9 = $ 45 30 @ $11 = $330 Total = $375 53 .Practice Problem: LIFO -Perpetual system Beginning Inventory 20 @ $ 9.00 $400 Purchase 1/22 30 @ 11.00 $180 Purchase 1/10 40 @ 10.00 $330 Sales on 1/13: 55 Units Ending Inventory: 20 + 40+ 30 .

Learning Objective LIFO Reserve and LIFO Effect 54 .

LIFO Reserve  Many companies use LIFO for external reporting and income tax purposes but maintain internal records using FIFO or average cost. 55 55 .. FIFO) and LIFO is reported in an account referred to as LIFO Reserve or the Allowance to Reduce Inventory to LIFO .  The difference in the value of inventory between the inventory method used for internal reporting purposes (i.e.

FIFO. which reflects the impact on income from using LIFO vs. 56 56 .LIFO Reserve  The change in the balance of LIFO Reserve account from one period to another is referred as the LIFO Effect.  The SEC required the LIFO reserve disclosure since 1974 for firms adopting LIFO costing.

Cost flow assumptions: The LIFO reserve disclosure Amount actually shown on balance sheet Amount shown on balance sheet if FIFO had been used 9-57 .

an indication of either deflation or a LIFO liquidation (discussed later). it indicates a greater LIFO COGS than FIFO COGS. This difference is the same as the 2005 COGS difference between LIFO and FIFO.LIFO Reserve (contd.   A decreased LIFO Reserve indicates a smaller LIFO COGS than FIFO COGS.  58 58 . an indication of inflation.000 in 2005.)  The LIFO Reserve decreased by $655. When LIFO Reserve increases.

EI=ending Inv.LIFO Reserve (contd. LIFO:   COGS = BI + Pur –EI COGS FIFO – COGS LIFO (BI=beg. Inv. a negative LIFO effect indicates COGS FIFO < COGS LIFO 59 59 .6 on p57) FIFO > COGS LIFO  Conversely. a positive LIFO effect indicates COGS (see the example in Exhibit 9.) =(BI FIFO – BI LIFO) – (EI FIFO – EI LIFO) =LIFO Reserve of BI – LIFO Reserve of EI   Thus.)  The proof of LIFO effect equals the COGS impact of FIFO vs.

LIFO and inflation: LIFO reserve Figure 9.4 Magnitude of Inventory and LIFO Reserve relative to CPI and Oil Prices 9-60 .

61 61 . or adopt just-in-time inventory management.)  When inflation heats up. restructure.LIFO Reserve and Inflation (contd.52 per barrel at the end of 2007 before dropped to $31. It was $85. the disparity between  LIFO inventory and FIFO inventory increases. Oil price was $16.84 by the end of 2008. Why did the LIFO reserve increase through 2007 and then decrease?   Firms reduce inventory levels as they downsize.75 per barrel at the end of 2001.

Learning Objective: Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net income. 62 .

LIFO Liquidation When prices rise .” 63 . This LIFO liquidation results in “paper profits. LIFO inventory costs on the balance sheet are “out of date” because they reflect old purchase transactions. . . If inventory declines. and earnings. these “out of date” costs may be charged to current COGS.

and therefore. This leads to a distortion in net income and a substantial increase in tax payment in the current period.LIFO liquidation  LIFO Liquidation occurs when a firm experiences significant inventory shortage. liquidate some layers in beginning inventory. 64 .   This results in costs from preceding periods being matched against current year’s revenues.

gross margin will be $32.LIFO liquidation: Illustration Old LIFO layers If recent inventory purchase is sufficient.000 65 .

000) What the per unit COGS would have been without the liquidation 66 .000= -4.LIFO liquidation: Calculation of LIFO liquidation profits The LIFO Reserve on 12/31/2005= 10 x $100+15x $200 = $6000.00010. LIFO effect of 2005 is (6.

000) was the difference.LIFO liquidation disclosures Income tax effect ($910. From footnote The buildup of the LIFO inventory creates the reserve. . 67 and the decline in inventory--known as LIFO dipping--is a liquidation of the reserve.

reduced COGS by (2.000 LIFO dipping undercharged expense and thus.)  Aral’s 2005 LIFO effect ($655. Reconciliation of Changes in LIFO Reserve: Rising input costs increased LIFO cost of goods sold by $1.945.000 (=Changes in LIFO Reserve) 68 . reducing LIFO Reserve.000) Result: LIFO COGS is less than LIFO by $ 655.000.600.000 decrease) is attributable to   LIFO liquidation profit in the amount of $2. and an inflation effect in 2005 in the amount of $1.600.000. increasing LIFO Reserve.LIFO liquidation Disclosures (contd.945.

69 . To avoid being misled by transitory LIFO liquidation profit.The Frequency of LIFO liquidation and Its Contribution to Pre-Tax Earnings  LIFO liquidation is not uncommon:  Figure 9.5 of the textbook indicates that during the period of 1985 to 2001. about 10% to 20% of firms using LIFO experiencing LIFO liquidation. on average.4% in 1991 to 2% in 2000. LIFO inventory footnote should be studied to see whether LIFO liquidation occurred and its impact to profits.   The contribution of LIFO liquidation to pre-tax earnings ranges from 10.

70 . a non-sustainable factor from gross margin analysis.Learning Objective: Remove LIFO dipping.

LIFO liquidation: Gross profit distortion Improving gross margin was reported But the improvement was due to LIFO liquidation 71 .

Current ratio example Eliminating LIFO ratio distortions : Current Ratio Understated because of LIFO LIFO reserve adjustment restates inventory to approximate current cost. 72 .

Eliminating LIFO Distortion: Inventory Turnover Rate Distorted by LIFO liquidation 73 .

the LIFO reserve decreased $4. The LIFO to FIFO adjustment is identical to the method used in Exhibit 9.538 during the year. COGS LIFO  $4.8.Partial LIFO use Most companies use a combination of Inventory cost flow assumptions.  Ending LIFO reserve Beginning LIFO reserve So.538  COGS FIFO 74 .

Tax implications of LIFO  U.S. LIFO must also be used in external financial statements. This LIFO conformity rule explains why so many firms use LIFO for financial reporting purposes.  9-75 . tax rules specify that if LIFO is used for tax purposes.

Tax implications of LIFO 9-76 .

000.   How fast inventory turns over during the period. x 10% cost increase Replacement COGS = 7.900.000 + 100.000 .Eliminating realized holding gains for FIFO firms  Reported income for FIFO firms always includes some realized holding gains during periods of rising inventory costs. The size of the FIFO realized holding gain depends on:  How fast input costs are changing.000 Realized FIFO holding gain 9-77 = 8.

Business cycles may cause extreme fluctuations in physical inventory levels.Reasons why some companies do not use LIFO  The estimated tax savings is too small (academic research confirms that LIFO firms have higher tax savings) .  The rate of inventory obsolescence is high.  9-78 .

9-79 .Reasons why some companies do not use LIFO  Managers may want to avoid reporting lower profits because they believe doing so will lead to:    Lower stock price Lower compensation from earnings-based bonuses Loan covenant violations  Small firms may not find LIFO economical because of high recordkeeping costs.

and still others use weighted-average. GAAP allows firms latitude in selecting a cost flow assumption. thus its often useful to convert LIFO firms to a FIFO basis. Reported FIFO income includes potentially unsustainable realized holding gains. Some firms use FIFO. 9-80 .Summary     Absorption costing can lead to potentially misleading trend comparisons. others use LIFO. This diversity can hinder comparisons across firms.

)    Similarly. Only then can valid comparisons be made across firms and over time. Users must understand these inventory accounting differences and know how to adjust for them. LIFO liquidations produce potentially unsustainable realized holding gains. Old.Summary (contd. out-of-date LIFO layers can distort various ratio comparisons. 9-81 .

82 .Learning Objective: Discuss the factors affecting a company’s choice of inventory method.

Decision Makers’ Perspective What factors motivate companies to select one inventory method over another? How closely do reported costs reflect actual flow of inventory? How well are costs matched against related revenues? How accurate is the timing of reported income and income taxes? 83 .

FIFO vs. LIFO: Comparison of FIFO and LIFO 84 .

. LIFO     Matches high (newer) costs with current (higher) sales. 85 . .Comparison of FIFO and LIFO When Prices Are Rising . Inventory is valued at approximate replacement cost. Is not allowed by the IASC. Results in higher taxable income and lower COGS.    FIFO Matches low (older) costs with current (higher) sales. Inventory is valued based on low (older) cost basis. Results in lower taxable income and higher COGS.

have lower quality than LIFO earnings) b. .Advantage and Disadvantage of FIFO Advantage a. match current sales revenue with old cost (earnings contains the holding gains and therefore. Inventory cost reported on the B/S is close to the replacement cost. c. Bad matches of sales revenue and CGS. Produce higher income during an inflation period. 86 Disadvantage a. . Less likely to be subject to management manipulation. b. Producing higher income during an inflation period results in paying more income tax.

Disadvantage a. result in tax savings.Advantage and Disadvantage of LIFO Advantage a. Subject to management manipulation. Produce lower income during an inflation period. . b. b. Inventory cost presented on the B/S is not fair. 87 . Good match of sales revenue with CGS(thus. higher earnings quality than FIFO earnings).

88 . Inventory write-downs and changes in inventory method are two additional inventory-related techniques a company could use to manipulate earnings.Earnings Quality Manipulating income reduces earnings quality because it can mask permanent earnings.

 Delay inventory purchases toward the end of a ―bad‖ earnings year so that COGS decreases when old LIFO layers are liquidated. 89 .Analytical insights: LIFO dangers   LIFO makes it possible to ―manage‖ earnings when inventory costs are rising! How?  Accelerate inventory purchases toward the end of a ―good‖ earnings year so that COGS increases.

Inventory Errors 90 .

 Due to the ending inventory will be the beginning inventory of next year.Inventory Errors Inventory errors are unique in financial reporting because they involve multiple accounts and multiple periods.  91 . the errors will be corrected by the end of the second year.

Inv. either overstatingInventories: the Measurement units or the value 92 . . under over Year 2 over under under over under over under a over b over under a. + Net .The Impact of Valuation of Ending Inventory on The CGS & Income Year 1 Income COGS = Beg. either understating the units or the value b. Inv.End.

here’s how the 2008 error will affect 2009 results: 9-93 . ending inventory is overstated by $1 million. Here’s the effect:  If not corrected.Inventory Errors: An Example  Due to a miscount in 2008.

94 .000 of goods in transit to the company when it performed the annual inventory count. at the end of 2001.Class Practice Problem     Assume that. How would this inventory error affect the financial statements for 2001 and 2002? Assume the cost flow assumption is FIFO. Xeron Corporation neglected to include $1. This error went undetected through 2002.

 Note that the asset account in inventory error analysis is ending inventory. and the equity effect is retained earnings. specifically the effect on net income. 95 . use the inventory formula and the balance sheet formula.Class Practice Problem To analyze.

no effect on 2002 ending Stockholder’s Equity.EI = COGS | NI | A = L + SE 01: 02: U U O U U O U X U X Why is there no effect on 2002 ending stockholder’s equity? NI 2001 understated by $1. Thus. but SE balance is offset by overstated of year 2002. so no net effect at the end.000 NI 2002 overstated by $1. SE in last year is understated. 96 .000 Both closed to RE.Class Practice Problem Analysis : BI: Beginning Inventory P: Net Purchase EI: Ending Inventory COGS: Cost of goods sold NI: Net income A: Assets L: Liabilities SE: Stockholder’s equity BI + P .

LCM Understand and apply the lower-of-costor-market rule used to value inventories. 97 .

When this occurs. 98 . GAAP requires inventory to be carried on the balance sheet at the lower of its cost or “market” value.Lower of cost or market   Inventory is presumed to be impaired when its replacement cost falls below its carrying value.

Lower of cost or market example Net realizable value: The amount that would be received if the assets were sold in the (used) asset market. 99 .

LCM and inventory aggregates  The lower of cost or market LCM method can be applied to:  Individual inventory items  Classes of inventory—say. fertilizers versus weed-killers  The inventory as a whole Three different answers 100 .

it violates the neutrality posture that financial reporting rules are designed to achieve.Criticisms of the LCM method    Write-downs may initially be conservative. LCM relies on an implicit relationship between input and output prices that may not prevail. But selling price and profit potential hasn’t changed LCM rule would require write-down 101 . but the resulting higher margin in the period following the write-down can lead to earnings management. Because LCM is conservative.

9-102 . but the inventory carrying amount cannot exceed the original cost.Global Vantage Point Comparison of IFRS and GAAP Inventory Accounting   IFRS guidelines for inventory are similar to U. IAS 2 allows inventory reductions to be reversed if the market recovers. Market is net realisable value (no ceiling or floor). GAAP Two important differences   LIFO is not permitted under IAS 2 Lower of cost or market is applied differently.S.

Estimate ending inventory and cost of goods sold Estimate ending inventory and cost of goods sold using the gross profit method. 103 .

1. Gross Profit Method Retail Inventory Method 104 .Inventory Estimation Techniques  Estimate instead of taking physical inventory   Less costly Less time consuming  Two popular methods are . 2. . .

. Determining the cost of inventory lost. Auditors are testing the overall reasonableness of client inventories. Preparing budgets and forecasts. Useful when . . 105 . destroyed.Gross Profit Method Estimating inventory & COGS for interim reports. NOTE: The Gross Profit Method is not acceptable for use in annual financial statements. or stolen.

3.Gross Profit Method This method assumes that the historical gross margin rate is reasonably constant in the short run. Net sales for the period. 4. Historical gross margin rate. Net purchases for the period. Cost of beginning inventory. We need to know: 1. 106 . 2.

Inventory + Net Purchases = Cost of Goods Available for Sale (COGAS)  3. COGAS . 2.Estimated COGS = Estimated Cost of Ending Inventory 107 . The above information needs to be available 4. Sales x (1 .Estimated Gross Margin %) = Estimated COGS Beg. Estimate Historical Gross Margin %.Steps to the Gross Profit Method 1.

400 •Gross margin = 43% of sales Estimate Inventory at May 31. At the end of May.000 •Net purchases for May = $728. 108 .213. uses the gross profit method to estimate end of month inventory. the controller has the following data: •Net sales for May = $1.Gross Profit Method Matrix.300 •Inventory at May 1 = $237. Inc.

000 x ( 1 .290 1.410 $ * COGS = Sales x (1 .300 965.400 728. 109 .700 (691.GM%) = $ = $ NOTE: The key to successfully applying this method is a reliable Gross Margin Percentage.Gross Profit Method Beginning Inventory Plus: Net Purchases = Goods Available for Sale Less: Estimated COGS* = Estimated Ending Inventory $ 237.410) 274.43% ) 691.213.

January-March $600.000 Inventory.Class Practice Problem . January-March 450. calculate the estimated ending inventory at March 31.000 If the gross margin has historically been 30 percent of sales.Inventory Estimation Given the following information from the general ledger: Sales.000 Purchases. January 1 50. 110 .

000 .Solution First.000 50.000 = EI 111 .EI = COGS 600. estimate EI: BI + P (net) .EI = 420. estimate COGS: If GM% = 30%.000 + 450.000 80. then COGS = 70% So Sales x 70% = COGS Then.000 x .7 = COGS = 420.

thus it’s often useful to convert LIFO firms to a FIFO basis. and still others use weighted-average. GAAP allows firms latitude in selecting a cost flow assumption. others use LIFO. 9-112 .Summary    Absorption costing is required by GAAP but can lead to potentially misleading trend comparisons. Some firms use FIFO. This diversity can hinder comparisons across firms.

out-of-date LIFO layers can distort various ratio comparisons. Similarly. 9-113 .Summary   Reported FIFO income includes potentially unsustainable realized holding gains. LIFO liquidations distort reported margins and produce unsustainable realized holding gains.  Old.

Most LIFO firms use some form of dollar-value LIFO. 9-114    . GAAP requires inventory to be carried at lower of cost or market (LCM). The LIFO conformity rules requires firms to use LIFO for financial reporting if they use it for tax reporting.Summary concluded  To address inventory obsolescence. IFRS accounting for inventory is very similar to GAAP. but LIFO is not allowed.

9-115 .Summary concluded   Users must understand these inventory accounting differences and know how to adjust for them. Valid comparisons can only be made across firms and over time after adequate adjustments.

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